Peter Lynch is considered one of the greatest investors of all time. As the manager of the Magellan Fund at Fidelity Investments from 1977 to 1990, Lynch averaged a 29.2% annual return, nearly doubling the S&P 500’s 15.8% yearly return over that time. His track record of success has left him as one of the most well-known and frequently quoted investors even over 30 years after his retirement.
A big part of Lynch’s enduring appeal is that his approach is grounded in common sense that the average investor can understand and apply. His philosophy revolves around the idea that everyday investors can find great opportunities by leveraging their own knowledge and experiences. An individual might gain an edge by noticing a new popular product or restaurant before professional analysts discover the stock.
However, while using your personal insight is a good starting point, ultimately Lynch believes you need to thoroughly research a company’s fundamentals before investing. Things like earnings growth, debt levels, and profit margins still matter. Lynch developed a systematic approach that investors can use to find profitable growth stocks.
The Lynch Strategy
The first step is to categorize a stock into one of six main types that Lynch uses:
1. Fast Growers – Companies with at least 20% annual earnings growth
2. Stalwarts – Large, steady firms with moderate 10-20% annual growth
3. Slow Growers – Mature companies with under 10% yearly growth
4. Cyclicals – Companies whose business follows the economic cycle
5. Turnarounds – Struggling companies attempting a rebound
6. Asset Plays – Firms with valuable hidden assets not reflected in the stock price
Lynch applied different criteria for each category, with the most focus on fast growers, stalwarts and slow growers. But one critical metric he used across all types of stocks was the P/E/Growth ratio, or “PEG”. The PEG divides a company’s price-to-earnings (P/E) ratio by its historical earnings per share (EPS) growth rate. The general idea is that the higher the growth rate, the higher P/E multiple a stock deserves. Lynch looked for PEG ratios under 1.0, and ideally as low as 0.5.
Some other core principles Lynch used for all stocks include:
– Avoid companies with high debt-to-equity ratios over 80%. He preferred firms with under 50% debt/equity.
– Check if inventories are growing faster than sales, a red flag.
– For financial firms, look for equity/assets over 5% and ROA over 1%.
– Bonus points for high free cash flow and net cash as a percent of the stock price.
When it comes to fast growers, Lynch sees 20-50% long-term EPS growth as ideal. Over 50% is unsustainably high. Annual sales should be over $1 billion and the P/E below 40 for large fast-growers. Smaller ones get more leeway on valuation. He also favors lesser known fast-growing firms only covered by a few analysts.
For stalwarts, Lynch narrows the EPS growth range to between 10-20%. He wants to see multi-billion dollar sales and consistent profitability with positive earnings per share. The company should be using its earnings to repurchase shares or pay a dividend.
Slow growers need to be large, with over $1 billion in sales, but are held mainly for their yield. The dividend yield should exceed the S&P 500 average, or at least 3%. By adding the yield to the EPS growth rate in the PEG calculation, slow growers can still be attractive if they pay hefty dividends.
Importantly, Lynch uses a few other non-quantitative guidelines to find good investments. He looks for companies that are expanding successfully and have duplicated their business in new markets. Brand name consumer goods or products that inspire repeat purchases are ideal. Simple, understandable businesses are preferred over those that are too complex. Insiders buying shares is also a good sign.
Like Peter Lynch himself, Validea’s Lynch-inspired model finds profitable, growing companies from a wide variety of industries. It primarily targets fast growers and stalwarts, with an occasional slow grower mixed in.
Some Top Scoring Peter Lynch Stocks
Here are three stocks that currently meet the tests of our Peter Lynch model.
Axos Financial (AX): Axos is a diversified financial services company providing banking, lending and investment services. It passes the Lynch methodology with strong scores as a “fast grower.” EPS has grown at a 18.7% rate over the long-term (using an average of the 3 and 4-year EPS growth rates), within Lynch’s preferred 20-50% range. Its PEG ratio is a very favorable 0.41. As a financial company, Axos also meets Lynch’s bonus criteria with an equity/assets ratio of 11.12% and return on assets of 1.77%.
REX American Resources (REX): REX produces and sells ethanol and related products like dried distillers grains, corn oil, and non-food grade corn oil. It gets high marks from the Lynch approach as a “stalwart” with a 22.5% long-term growth rate, $1.1 billion in sales, and a PEG of just 0.16. As a non-financial company, it also boasts a low debt/equity ratio of 0.04%. REX has grown earnings at an accelerating rate over the past several quarters, another quality Lynch looked for.
Heritage Insurance Holdings (HRTG): Heritage provides personal and commercial residential property insurance. Lynch would classify it as a “fast-grower” with a 46.39% long-term EPS growth rate and a strong 0.34 PEG ratio. The company is taking market share in an expanding industry (property insurance) and has posted positive EPS in each of the past 7 years, showing the consistency Lynch favored. As a financial firm, Heritage also passes the bonus criteria with a stellar 31.87% equity/assets ratio and 9.85% return on assets.
Additional Research
